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2014 Outlook for PIK Offerings

The riskiest types of corporate bonds are getting a makeover, providing more protection for investors while showing the limits of a rally in junk-rated debt that pushed yields to a record low.

Issuers from Neiman Marcus Group Ltd., which sold in October $600 million of notes that allow it to make interest payments in more debt instead of cash, to Jacksonville, Florida-based Bi-Lo Holdings LLC led $14.8 billion of payment-in-kind (PIK) offerings in the U.S. last year, the most since 2008, according to data compiled by Bloomberg and Fitch Ratings. The 36 issues were a record.

While the bonds became popular during the last credit boom before the downturn, the new generation of securities are smaller in size, come from companies with less leverage, and some compel borrowers to pay interest in cash unless they violate certain financial targets. These protections show that investors are treading carefully even as they search for additional yield amid unprecedented central bank stimulus measures that pushed interest rates to all-time lows.

“The issuance of PIK tends to move the same way as the credit cycle, and credit has been loosening,” Sharon Bonelli, a managing director at Fitch in New York, said in a telephone interview. Still, “the market is not as aggressive as it was.”

Last year, sales of PIK bonds were the third most on record, behind the $16.2 billion in 2007 and $14.9 billion in 2008.

The Federal Reserve has held benchmark rates near zero since 2008, forcing investors into riskier securities to get extra payouts. Average yields on junk debt, rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s, fell to a record-low 5.98 percent in May 2013 before rising to 6.21 percent on Jan. 22, according to the Bank of America Merrill Lynch U.S. High Yield Index. Junk sales in the U.S. reached an unprecedented $373.9 billion last year.

“It’s a sign of a healthy, growing market that we saw so much PIK issuance last year and we will see even more this year,” said Martin Reeves, London-based head of high yield at Legal & General Investment Management, which oversees more than $700 billion globally. “People are investing in PIKs because they expect economic growth to pick up.”

The U.S. economy is expected to expand by 2.8 percent this year, up from 1.9 percent in 2013, and by 3 percent in 2015, according to economists surveyed by Bloomberg.

Funds for Dividends, not LBOs

Issuers are relying less on the securities, with the average size of PIK bonds in 2013 falling to $410 million from $647 million from 2007 to 2008, according to a Jan. 21 Fitch report. Proceeds last year were mostly used on dividend payouts to private-equity sponsors and to refinance debt rather than to help fund leveraged buyouts (LBOs), as was the case before the financial crisis when PIKs were used for the takeovers of Energy Future Holdings Corp. and First Data Corp.

Companies that have sold PIK bonds from 2011 to 2013 had average leverage, or the ratio of debt to earnings before interest, taxes, depreciation and amortization, of 7.2 times, down from 9.4 times for borrowers issuing from 2005 to 2008, according to Fitch.

“A number of PIK issuers have been relatively stable performers through the great recession,” Lenny Ajzenman, a New York-based analyst at Moody’s, said in a telephone interview. “That’s one way that some investors are gaining some comfort. They are often investing in a company that is highly levered but has been a steady performer.”

Limitations on In-Kind Payments

Rules written into the contracts of new bonds can limit when issuers can defer cash payments in favor of so-called in-kind payments, which accrue as additional principal and increase the amount of debt due at maturity, according to Fitch.

Neiman Marcus’s $600 million of PIK securities that mature in October 2021 pay an 8.75 percent coupon in cash and 9.5 percent if the company defers payment, Bloomberg data show. The Dallas-based retailer must make its first two interest payments in cash and can only make a maximum of six in-kind payments over the life of the bonds, according to Fitch.

That compares with Neiman Marcus’s $700 million of PIK bonds issued in September 2005 that allowed it to pay either in cash or in-kind for the first five years, Bloomberg data show.

The new slate of PIKs increasingly require the borrower to make cash payments unless certain financial thresholds have been breached, Bonelli said. These contingent cash-pay securities—dubbed “pay-if-you-can” bonds—can be linked to items such as restricted payments tests, which limit cash outflows through dividends and other payouts, liquidity, or leverage ratios.

Bi-Lo, the Southern U.S. grocery chain, issued $475 million of five-year PIK notes on Sept. 17; they have an in-kind payment option at 9.375 percent that is triggered by the company’s restricted payment capacity under its credit agreement, according to Fitch. The less capacity the company has, the greater the portion of its interest it can defer, safeguarding Bi-Lo’s financial stability in the event cash flows deteriorate.

During the financial crisis the payment-in-kind structure became associated with overeager debt-issuance practices, and the recent spate of offerings has caught the attention of international regulators.

Low interest rates can push investors to seek debt with looser terms in the hunt for yield, which can ease refinancings, keeping troubled borrowers afloat, the Basel-based Bank for International Settlements, which was formed in 1930 and acts as a central bank for the world’s monetary authorities, wrote in a Dec. 8 report.

“PIKs are characteristic of a frothy credit environment,” Moody’s Ajzenman said. “The one saving grace is that there is additional protection that forces the issuer to pay cash as long as it has capacity. It’s a modest check on an aggressive structure.”

Refinancings

Elsewhere in credit markets, the cost to protect against losses on corporate bonds in the U.S. and Europe jumped to the highest in more than a month. Delta Air Lines Inc. is seeking to reduce the rate on $1.49 billion of loans, according to a person with knowledge of the transaction.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, climbed 4.1 basis points to 71.9 basis points at 11:25 a.m. in New York, the highest intraday level since Dec. 6, according to prices compiled by Bloomberg. In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings increased 8.4 to 84.1.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, added 1 basis point to 15.09 basis points, the highest intraday level since Sept. 25. The gauge typically widens when investors seek the perceived safety of government debt and narrows when they favor assets such as corporate bonds.

Delta, the third-largest U.S. carrier, is proposing to lower the rate on a $1.09 billion B-1 loan due in October 2018 and a $396 million B-2 piece due in April 2016, said the person who asked not to be identified without authorization to speak publicly.

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